Bank of Japan policy easing possible?

On January 10, the Bank of Japan (BoJ) released the interim review of its Outlook for Economic Activity and Prices published in October. In the interim report, the bank acknowledged that the economy had recently been weaker than envisaged in its standard scenario for growth, but it maintained the forecasts for 2008 contained in last October's Outlook report. The weakness was attributed to temporary factors, such as the adverse impact of a revised Construction Standards Law on housing.

Despite this weakness, the bank claimed that the basic mechanism of increased production supporting greater incomes and expenditures remained intact. The bank does not formally indicate the risk balance of the economy, as the Fed does, but it virtually clarified its downward risk bias by citing uncertainties about global economic growth and international financial markets, as well as high costs of energy and other natural resources.

Recently, several BoJ officials have indicated that the bank might have to pursue a monetary policy appropriate to circumstances. This could be interpreted as simply a restatement of the principle of a forward-looking approach to policy, but it could also be an attempt to prepare the markets for a cut in interest rates. It could even be a risk hedge for the BoJ, and a gradual approach to abandon its current stance of gradually raising interest rates in the future.

If the BoJ were to ease policy, it could do so in one of at least two ways. First, it could maintain its current growth forecasts and claim that some easing was needed to reduce the risk of current market turbulence to future growth. This approach might be taken if the BoJ considered sustained yen appreciation and share price weakness to threaten real economic growth significantly. This approach would also be consistent with co-ordinated interest rate declines by central banks around the world. Second, it could abandon its current growth forecasts and fundamentally change its policy stance. This would also require a change in its standard scenario for economic growth and prices.

On January 25, in testimony before the Budget Committee of the House of Representatives, BoJ Governor Fukui showed a negative stance towards lowering interest rates in concert with other central banks, so we do not expect the BoJ to lower rates soon. It would most likely lower rates only if downturns in the US and European economies were to threaten global economic growth and Japan's.

In August 2000, the BoJ abandoned the zero interest rate policy it had been pursuing until then. To deal with the fallout from the collapse of the IT bubble, the BoJ was forced to adopt a quantitative easing policy in March 2001. If we look at the months preceding this adoption, we notice a pattern in how the BoJ justifies its change in the policy stance. The pattern of disclosure is first, to qualify the previous evaluation with an introductory negative comment, then to move the negative development to after the evaluation, and finally, to shift to a negative evaluation.

Until last November, the BoJ had simply stated that the economy was continuing to expand gradually. In December and January, it stated that although growth was slowing due to such factors as a drop in housing investment, the economy con-tinued to grow gradually. Thus, the first change in economic evaluation has been made. The sub-prime mortgage shock does not threaten Japan's economic growth as significantly as the IT shock did, so the BoJ may take more time to change its evaluation of the economy than it did in early 2001.

We currently see a 30 per cent chance of a drop in interest rates in the April-June quarter, but if there is another change in the wording of the evaluation of the economy, an interest rate drop could become more imminent.

Some observers expect that if the BoJ were to ease policy, it would simply extend the current rates with some commitment about the circumstances needed for a hike. However, the market has already given up on another rate hike in the near future, so maintaining current rates with a time frame would not have much effect. At the same time, if the BoJ were to commit to maintaining current rates too strongly, it would lose flexibility in executing monetary policy. The overnight call rate is only 0.5 per cent and the BoJ could only cut this to zero, which would not have much of a stimulatory impact on the economy.

Still, a cut in the rate would more strongly convey the fact that the BoJ has reversed its appraisal of the economy and its monetary policy stance than simply prolonging the current rate with some commitments.

Note: The 'Currency Outlook' of February 3 was referring to the Reserve Bank of Australia and the Reserve Bank of New Zealand.

This report was compiled by the Marketing Department of HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.